"Cotton, the fabric of our lives." –Famed television tagline
"All of our brands, every single brand, will take some price increases." –CEO of apparel maker, VF Corp.
It never ceases to amaze me, the speed of time when monitoring the stock market on a tick by tick basis. One minute you are reading about the lighting of the storied Rockefeller Center Christmas tree on the Blackberry, and the next minute you are in the mall inundated with bright spring colors. The moment is upon us once again when retailers officially share the books on their holiday season performance. By and large we know what is in store, primarily solid positive comparable store sales, profit margin expansion, and double-digit percentage earnings growth. Those retailers that have reported for holiday thus far have left me impressed, with strong EPS beats being the norm rather than the exception.
Coach (COH) kicked things off with a bang in late January. The accessible luxury handbag and accessories purveyor surprised consensus on earnings as consumers enthusiastically embraced holiday collections in the U.S., while increased exposure to the hot China retail market served as icing on the proverbial cake. Coming as little shock, management sounded the alarm bell regarding the input cost backdrop, but conveyed an overall outlook that was upbeat owing to optimism on the consumer domestically and price increases scattered about the assortment for spring.
Next on the docket were the somewhat dry home furnishings companies Ethan Allen (ETH), Furniture Brands (FBN), and La-Z-Boy (LZB). The two fundamentally sound companies, Ethan Allen and La-Z-Boy, had more than a pop in their share prices on release day, a reflection of a shift in tone by the respective management teams. The furniture customer, sitting on the same couch for longer than five years, has tiptoed their feet back into the market. The sales are being derived from upgrades by existing homeowners, and that only arises if confidence in the 12-month employment outlook and access to reasonable interest rates on credit lines exist. Encouraging signs? You bet.
How can we overlook the recent earnings from footwear companies Columbia Sportswear (COLM) and Timberland (TBL)? These companies blew the doors off consensus estimates, and it was not solely a function of Mother Nature wreaking havoc on the feet of human beings in the U.S. and Europe. Consumers were open to fashion purchases in boots, another positive tidbit.
In reading between the lines, the piece of string that attaches all these short recaps together is a consumer in the U.S. that is back from the ledge and a European consumer that is bucking conventional wisdom (keeping in mind the EU fallout).
Drilling down into the U.S., what initially started as a consumer spending recovery by way of savings depletion is broadening out to spending from weekly wages on non-essential goods and services. Yes, to hear Wal-Mart (WMT) pronounce the paycheck cycle is still an issue and to see strong traffic gains at dollar stores Family Dollar (FDO) and Dollar Tree (DLTR) are indications that all is not 100% fine and dandy in the U.S. economy. A frictional consumer spending recovery may be a valid interpretation of the progression. Upper-income households, which have participated greatly in the rebound in equity values, are spending with no denial. Middle-income households, while still shocked at the speed of decline in the value of their retirement and equity accounts in 2008/2009, have opened up the newspaper to see an unemployment rate that is beginning to moderate. In turn, that is propelling spending, though a deal remains an important consideration to actually purchasing a product.
As for the lower-income consumer, things may be getting worse as already stretched budgets are stretched further from elevated gasoline prices, food prices, and structural shifts in the labor market that make advancement or a pay upgrade harder to attain. Hence, the impressive traffic gains at dollar stores, and one explanation as to why investor Nelson Peltz is willing to orchestrate an aggressive bid for Family Dollar (the other...my theory is dollar stores are a way to cash in on baby boomers retiring less wealthy than first thought).
The Major Themes of 4Q Earnings Season for Retailers
- Strengthening of the U.S. consumer spending rebound translating to comparable store sales above consensus forecasts in November and January. December was inflicted by very unfavorable weather for most of the month, and generally sales missed forecasts. Additionally, online sales were the star of the quarter as consumers embraced the ease of use, deals, exclusive products, and site to store.
- Another quarter of operating expense leverage.
- Utilization of cash on share repurchases.
- Inflation a non-issue.
- China, uber robust (and that may be putting it lightly).
Some Economic Flavor Behind the Results
- Conference Board: On an uptrend since September 2010 (headline and present situation components).
- Michigan: More Americans think the unemployment rate will decline, critical in spurring consumption.
- Overall: Though confidence has returned, it remains well below peaks set in the previous economic expansion. Consumer spending has been a positive contributor to GDP for over a year.
- On a monthly basis, price declines have slowed and refis have helped to bring down monthly expenditures. Mailing in of the ole house keys (underwater on the mortgage) is another spending driver that has gone unmentioned.
What I am Hearing to Begin the Year
- * A dialogue shift from worrying about the pace of sales to worrying about forward margins. Commonly, the sales backdrop is stable and if the product and marketing are correct, the consumer is showing up. Costs are clearly in focus, with cute fluffy cotton not being a retailer's friend. Ditto transportation and utilities costs.
- * To combat inflationary headwinds, retailers will take the path adorned with creativity. Product is being re-engineered to include cheaper blends and fewer buttons/zippers. Some in the sector have assumed a different posture, preferring to boost the level of product detailing in order to justify a higher ticket price. First half price increases appear to be in the range of 5% to 8%, but will bump up to 10% to 15% in the second half of the year. Retailers will use the inflation dominant headlines to the fullest extent possible, raising prices on premium products and succinctly on basics. This is all of interest to me. Assuming the consumer does not retrench, retailers will be driving sales of higher priced goods on good volume. With analysts marking down their earnings estimates following cautious 1Q guidance, retailers may be poised to surprise on earnings this year. Those who have announced price increases include Brooks Brothers, Polo Ralph Lauren (RL), Coach, VF Corp. (VFC), Levis, Ethan Allen, Steve Madden (SHOO), and Jones Apparel Group (JNY).
- * Price increases are really being pushed on the international consumer by Western retailers.
- * Capital deployment on new share repurchase programs, increased dividend payouts, online, and China. Many retailers are in the process of website redesigns to include customer reviews and better integration between stores and smartphones. Facebook and Twitter have become important to a cohesive marketing strategy. Regarding China, expansion on the Mainland is spreading to development into Tier 2 and Tier 3 cities.
Early Season Creativity Awards
Urban Outfitters (URBN), Ethan Allen, and Walgreen (WAG) hold down the top spots. Urban's website is quite engaging, providing real-time customer reviews. Additionally, the company just added an employee of the month function on its website, personalizing itself to the consumer. Ethan Allen has offered free interior design services for over a year, but has added a function on its web store that gives the background of interior designers at nearby stores. Another example of personalizing a large store chain. Walgreen's smartphone app allows consumers to scan a barcode on a script bottle, which will automatically trigger a refill to be picked up at a store. Convenience at its finest.
Retailers are moving from "safe" product in black and neutral color palettes to items with pizazz. A view of the Nordstrom (JWN) online footwear department is an example of more interesting products this spring season. Also, the trends at Fashion Week seemed more colorful for fall 2011. These efforts are being done to excite a consumer that is in a better financial standing relative to the depths of the downturn.
Pull up a 12-month chart on the S&P Retail Index (RLX) and it's easy to assume the entire sector is overvalued. I don't think that's the case, and opportunities do exist to play the evolution of the spending recovery and the acceleration of sales and margin gains in emerging growth markets. While the tide of the broader stock market's rise lifted the ships of many a consumer discretionary stock in 2010, by developing a viable investment thesis first and then doing the homework to see where the individual risk reward is favorable portfolio gains could be logged in 2010. Why are valuations on select consumer discretionary stocks still attractive? Well, I sense a continued distrust in the sustainability of the renewed consumer spending vigor by the market, which is holding back multiples. Basically, the earnings base increased appreciably in 2010, but multiples have failed to keep pace.
1. Estimate demolishers: These companies have the product that the consumer yearns for and can get away with price increases, which compliments a building international presence. Two direct ways to play are Abercrombie & Fitch (ANF, if the consumer will be forced to pay a higher price, why not make it a quality buy; international momentum) and Timberland (TBL, market share gainer in the U.S.; surprising China strength). Derivative investment is shoe retailer Finish Line (FINL), which is selling the products the consumer is demanding from the likes of Nike (NKE) and Timberland, and the valuation is cheap.
2. Mispriced opportunities: Interestingly, Macy's (M) is trading on a P/E multiple of 10x estimated forward earnings, a stark discount to its department store peers. I think Mr. Market is off base here. The core Macy's brand has been a share gainer, Bloomies taps into upper-income spending, and online continues to be a standout. Moreover, operating expenses have been nicely controlled, and I think a significant amount of debt will be wiped clean from the slate in 2011 (frees up cash for shareholders).
3. Takeover roulette wheel: We have seen all sorts of private equity activity in retail, starting with J Crew and Jo-Ann Stores last year. What we haven't gotten yet is a retailer for retailer transaction arising from a strategic need to gain scale in certain markets. Discount retailer Fred's (FRED) is my call on this theme, with the suitors being CVS (CVS) or Walgreen (WAG).
4. Trader's delight: A riskier strategy no doubt. It centers on taking a position in a retailer that has announced that it's exploring strategic alternatives or has been rumored to be exploring options. To undertake this trade, a case has to be made that if a deal is done, it will be at a significantly higher price than the current market price (compensates for the risk of no deal). Two names are Big Lots (BIG) and BJ's Wholesale (BJ). Big Lots has reportedly begun the exploratory process as to its options to maximize shareholder value. The stock is trading at $41.00, but if I push the modeling to the max I think the company is worth $49.00 per share. BJ's Wholesale is officially exploring options, and activist Leonard Green is in the mix on this one. I think by making aggressive free cash flow assumptions the company is worth $55.00, above the current $49.00 share price.